OREANDA-NEWS. March 18, 2013. At its regular meeting the Bank of Latvia Council discussed the latest tendencies of Latvia’s macroeconomic development and took decisions regarding future directions of monetary policy.

The main conclusions are related to inflation dynamics, economic growth and development of lending.

Inflation
First, about inflation. The just published February data indicate that the downward trend that inflation has followed has been consistent: in January, the inflation rose by an annual 0.6% and in February by 0.3%. The average annual inflation in February was 1.8%.

For several months running, Latvia’s inflation indicators have been among the lowest in the European Union and it is possible that as early as February Latvia will join the referential criterion group among the three EU countries with the lowest inflation in terms of the average inflation indicator of the last 12 months.

The consistently low inflation in the first months of the year has resulted both from the drop in administrated prices (primarily those of thermal energy and natural gas) and the stable energy prices in the global markets. The February inflation in Latvia was primarily determined by the drop in the sales price of natural gas (determined by the nine-month average mazout price), bringing along a change in thermal energy tariffs, as well as the still ongoing discount sales of wearing apparel and footwear. The annual inflation in February dropped primarily because of the rises in fuel prices and foodstuffs prices that were lower year-on-year.

At the moment we can assert that no risk of rising inflation is posed either by changes in producer prices or the labour market. The monthly rise in producer prices in January was a mere 0.1% for the production sold domestically. Over this year, a number of domestic factors will also have a beneficial effect on energy prices: in the coming months, a positive impact could be had by the sales price of natural gas and, on thermal energy prices in, e.g., Rezekne and Riga, by a drop in other costs.

Nor are there substantial inflation risks imminent from the perspective of the labour market. The assessment of labour shortages as seen by entrepreneurs has stabilized and the number of vacancies is gradually returning to the level before the rapid growth. Even though a small rise in salaries is expected in the future, overall it will match the rise in productivity, without increasing production costs and thus not creating a pressure on prices.

One factor that has the potential of raising inflation this year is the liberalization of electrical energy market expected in autumn in combination with a rise in the mandatory procurement component in the consumed electrical power. The impact on inflation is currently assessed as rather insignificant: assuming that the freeing of the market takes place in September, the possible appreciation of electrical power could bring up this year’s annual inflation by about 0.2 percentage points.

The actual low inflation in January and February as well as the possible drop in thermal energy prices in the middle of the year allows us to reduce the evaluation of the average annual inflation for 2013 to 1%, while keeping in mind the indirect impact of electrical energy prices and the uncertainty regarding foodstuffs prices in the new harvest season.

Gross domestic product
As we have stated before, the slowdown in growth rates elsewhere in Europe will have a delayed effect on Latvia as well – as is gradually becoming the case right now. The first data for this year point to certain slowdown in manufacturing growth. Manufacturing production output in January 2013 dropped by 3.6%. This is a month-on-month drop, seasonal factors excluded. The annual growth rate also went down substantially. As a result, the amount of manufacturing production is the same as in January of last year.

In a breakdown by sub-branch, a substantial drop in production volumes was experienced in the unstable pharmaceuticals industry (minus 17.1%) and repairs of equipment and appliances (minus 18.3%). In the larger branches of manufacturing growth rates have unfortunately been negative. Thus output volumes dropped in the production of construction materials, chemicals, wood and wood pulp as well as wearing apparel and textiles. Slight growth was the case only in the production of furniture, metals and fabricated metal products as well as foodstuffs.

The industry confidence indicator aggregated by the European Commission has not dropped, yet it is still unclear what the development of several of Latvia’s European trading partner will be in the near future. Given the crisis in the European construction industry and thus a reduced demand for construction materials, it is expected that growth will be weaker year-on-year in wood and wood pulp production (particularly in those enterprises that manufacture production with lower value added), production of metals and possibly also of rubber and plastics. The lower growth rates in the automobile industry in Europe will in all likelihood have a negative impact on the producers of various components in Latvia. The food industry is expected to experience stable development, yet have relatively low growth rates.

Overall, it elicits caution, when assessing the potential growth of Latvian industry this year. After the thorough discussions at our January conference we can safely say that there is no reason to change Bank of Latvia’s projections of GDP growth base scenario for this year, which is at 3.6%, irrespective of a better end of last year, which allowed the gross domestic product growth to add 0.1pp, reaching 5.6%. It is a well known fact that the manufacturing sector has demonstrated amazingly good results also before, exceeding expectations. We will only be happy if the competitiveness of Latvian producers turns out to be stronger than predicted also this year.

To a great extent, the decisive factor here will be the recovered competitiveness of the country.

On crediting growth
In the second half of last year, the drop in lending has slowed substantially, moreover, because of lending to enterprises. The drop in the domestic loan portfolio as of June 2012 (-280 mil. lats) has almost entirely taken place on the account of dropping lending to households. According to the survey on bank lending conducted by the Bank of Latvia in January, the policy of lending to businesses has not changed substantially (tightening slightly in regard to households).

The main engine behind the resumed lending to enterprises has been electrical energy branch, as well as agricultural and transport branches, whereas the rate at which lending is shrinking vis-a-vis all the other major branches, including manufacturing, is slowing.

Finally, about the Bank of Latvia’s resolutions adopted today.

The conclusion to be drawn from all of the above: the economic recovery and currently successful economic growth – currently highest in the European Union – do not pose risks to price stability in the medium term. Despite the high rate of growth, inflation in Latvia remains at a low level and, as I mentioned before, our current prediction has been adjusted from 2 to 1%. At its meeting today, the Bank of Latvia Council therefore resolved to leave the interest rates and mandatory reserve requirement unchanged.